Can Europe Pull Germany From Fantasy Land?

We sympathize with Germany's position in Europe. They understand it will be
much more difficult to see over-extended budgets brought back into line after
checks have been passed out (again). Germany's bargaining power remains strongest
when bond market pressures are high in Italy and Spain. If your house is on
fire, a guy with a bucket of water is in a good bargaining position.

The recent spike in Spanish and Italian bond yields has moved Germany's leverage
into "playing with fire" territory. The Germans are living in fantasy land
if they think their current path will calm bond market investors.

At the 13:27 mark of a popular December 2011 video,
we explain why rising bond yields can create an unsustainable situation or
crisis. In the long run, we believe Germany is taking the proper approach to
create sustainable growth. However, as we noted on June
15, Germany's timetable is radically different from Wall Street's, which
is where the fantasy land analogy applies.

Prior to the next in a long series of "make or break" summits, Europe looks
like two rams competing for an attractive mate, rather than an united market-friendly
union.

European leaders sound unusually divided before a high-stakes summit,
with Germany's Angela Merkel saying total debt liability would not be shared
in her lifetime and giving little support to Italian and Spanish pleas
for immediate crisis action.

Shortly after being appointed to lead Italy from the financial abyss, Mario
Monti was dubbed "Super Mario" by the Italian press based on his ability to
get things done. The Bloomberg excerpt
below highlights why the bond market continues to shy away from Italian debt
despite Monti's progress:

Unfortunately, Monti has inherited an accumulated public debt large enough
-- at 120 percent of GDP -- to overwhelm his efforts to close the gap between
current revenue and outlays. With investors' confidence rattled, the cost
of rolling over the debt is becoming prohibitive. If the bond yield --
currently hovering around 6 percent, up from 4 percent two years ago --
stays high enough for long enough, the country will be insolvent.

Germany's current approach will most likely need to be supplemented with some
less-than-desirable moves in order to get the burning bond market back under
control. Reuters summarizes
Italy's position heading into this week's meetings:

Monti said he would repeat his call for the European Financial Stability
Facility and the European Stability Mechanism, the two funds set up to
provide a "firewall" against the spreading debt crisis, to be used to help
ease the pressure on Italian debt. Italy is proposing to use the funds
to help limit the spreads over German Bunds on bonds issued by countries
that respect EU budget rules. The proposal has run into stiff opposition
from Germany, the largest economy in the European Union and the bloc's
effective paymaster, and has been rejected by Jens Weidmann, the powerful
head of the German central bank, the Bundesbank.

Spain and Italy are both under extreme funding stress. Therefore, it is not
surprising they are pushing for similar assistance, which falls outside of
Germany's comfort zone. From Reuters:

Spain is determined to retain access to market funding and will push
for European institutions to use available options to stabilize financial
markets, premier Mariano Rajoy said, maintaining his policy stance ahead
of an EU summit.

Ms Merkel told the German Parliament on Wednesday ahead of a European
Union summit there is no "magic formula" that will make the crisis immediately
go away. She insists that Europe must tackle its problems at the roots
- which she says are a lack of competitiveness and high debts - in a step-by-step
process. Ms Merkel says any other approach is condemned to failure. "It
is imperative that we don't promise things that we cannot deliver and that
we implement what we have agreed," Ms Merkel said to loud applause in the
chamber. "Joint liability can only happen when sufficient controls are
in place," she added.

Charles Dallara, managing director of the Institute of International Finance
(IIF) and a key negotiator in the restructuring of Greece's debt, represents
the view of large buyers of sovereign debt. From Reuters:

"This is about winning back the confidence of long-term oriented investors
such as pension funds and insurance companies - and I fear that they will
be convinced only by comprehensive solutions."

We often read that financial markets are addicted to stimulus and policy intervention,
almost implying something is wrong with the markets. Unfortunately, the markets
are acting in a very rational manner. Markets know the entire financial system
has been propped up with deficit spending, printed money, manipulated interest
rates, and taxpayer bailouts. For those who point to strong earnings and fundamentals,
we invite you to answer these questions:

If the global economy was fundamentally sound, why have policymakers kept
interest rates at near zero levels? Why are they willing to commit to keeping
them low for a long period of time?

Why have historically low rates not sparked more growth or inflation?

What would growth and corporate profits have looked like without unprecedented
global stimulus (spending money we do not have), money-printing, and near-zero
interest rates?

The answers to many of the questions above relate to unhealthy balance sheets.
As we outlined in an October 2010 video,
rather than purging bad debts from the system, policymakers have attempted
to repair the asset side of balance sheets. The process of "stimulating" asset
prices works for a time, but the markets eventually come off their sugar high
and realize no one wants to deal with the debt, with the exception of Germany.
Germany is often cast as the hard-line villain in the media. The harsh reality
is many debts around the globe must go through a restructuring process. It
is and will continue to be very painful, but on the other side, confidence
will return and sustainable growth will follow. We will have sluggish growth
for a long time unless the debt is purged from the system.

Mario Monti has stated he is willing to work into Sunday night in an effort
to make progress before the markets open on Monday. Therefore, investors hoping
for some significant news this week may be disappointed. Our investment approach
remains unchanged:

If key levels above 1,240 are breached on the S&P 500, a deflationary
decline could move fairly rapidly toward 1,160, just as stocks moved rapidly
in a bullish manner from 1,260 to 1,320 in early 2012. The bull/bear demarcation
lines are outlined in a June 22 video.
As shown below, from a short-term perspective, the bulls have made some progress.

Since some technical strings remain untied, the most difficult scenario to
deal with from a probabilistic perspective is that stocks have already put
in the low for 2012. This scenario will gain traction if the S&P 500 can
close above 1,325 followed by 1,354.

Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at www.ciovaccocapital.com.

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but we cannot attest to its accuracy. Investment recommendations may change
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Ciovacco Capital Management, LLC is an independent money
management firm based in Atlanta, Georgia. CCM helps individual investors and
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